Investment Management Group Update 2007-07 May 2007 Legal Update: If you have questions or would like additional information on the material presented herein, please contact: Jay S. Neuman 412.288.7496 jneuman@reedsmith.com or Frederick C. Leech 412.288.4178 fleech@reedsmith.com Investment Management Group C. Grant Anderson Andrew P. Cross Timothy S. Johnson Gail C. Jones Stephen A. Keen Stefan Kugler Frederick C. Leech Rene M. Lochmann George F. Magera Ritu M. Manjunath Lisa D. McAnany Daniel M. Miller Kary A. Moore Donald J. Myers Jay S. Neuman Thao H. Ngo Stacey C. Palmer Justine S. Patrick Alicia G. Powell Michael B. Richman Leslie K. Ross James G. Whetzel Travis E. Williams Nelson W. Winter Rana J. Wright Todd P. Zerega NASD Proposes Interpretive Material on "Business Entertainment" On May 15, 2007, the SEC issued for comment a proposal by the NASD to adopt "Interpretive Material" (IM) to NASD Rule 3060 that would provide new, "principles-based," guidance on the subject of allowable "business entertainment," and would require members to adopt new and very detailed policies and procedures in this area. Rel. No. 34-55765; available at http://www.sec.gov/rules/sro/nasd/2007/34-55765.pdf. Highlights of the proposal are summarized below. The NASD previously issued a proposal on this subject for comment in Notice to Members (NtM) 06-06, January 2006; and published additional guidance in NtM 06-69, December 2006. Dates: Comments on the proposal are due to the SEC no later than 21 days following publication of the Release in the Federal Register (expected during the week of May 21, 2007). If the proposed IM is approved by the SEC, NASD currently intends to make the new requirements effective six months after the approval. Background Currently, NASD Rule 3060 generally prohibits members and their associated persons from, directly or indirectly, giving (or permitting to be given) anything of value, including gratuities, in excess of $100 per individual per year to any person, principal, NEW YORK LONDON proprietor, employee, agent or representative of another CHICAGO person where such payment is in relation to the business of PARIS the employer of the recipient of the payment. A gift of any LOS ANGELES WASHINGTON, D.C. kind is considered a gratuity. In addition, NASD Rule 2110 SAN FRANCISCO ("Standards of Commercial Honor and Principles of Trade") PHILADELPHIA requires a member, in the conduct of its business, to PITTSBURGH OAKLAND "observe high standards of commercial honor and just and MUNICH equitable principles of trade." PRINCETON As explained in the Release, Rule 3060 is designed to "protect against improprieties that may arise when members or their associated persons give gifts or gratuities to employees of a customer." In response to an interpretive This text is presented for informational purposes and is not intended to constitute legal advice. “Reed Smith” refers to Reed Smith LLP, a limited liability partnership formed in the state of Delaware. © Reed Smith LLP 2007. All Rights Reserved. N. VIRGINIA WILMINGTON BIRMINGHAM, U.K. ABU DHABI DUBAI CENTURY CITY RICHMOND GREECE r e e d s m i t h . c o m request, the NASD staff in 1999 issued a letter stating that Rule 3060 does not prohibit “ordinary and usual business entertainment” (such as an occasional meal, sporting event, theater production or comparable entertainment event), provided that such entertainment is “neither so frequent nor so extensive as to raise any question of propriety." This interpretive position was based in part upon NASD's rules governing non-cash compensation in connection with the offer and sale of investment company shares and variable annuities. Citing recent reports and enforcement proceedings relating to what might be seen as unusually excessive entertainment provided by certain brokers to certain customer employees, NASD is proposing to add the new IM to Rule 3060 to more explicitly address business entertainment practices. The proposed IM would supersede any prior guidance on this subject, including the 1999 letter referenced above. The Proposed Interpretation Reed Smith is a top-15 global relationship law firm with more than 1,500 lawyers in 21 offices throughout the United States, Europe and the Middle East. Founded in 1877, the firm represents leading international businesses from Fortune 100 corporations to mid-market and emerging enterprises. Its attorneys provide litigation services in multijurisdictional matters and other high stake disputes, deliver regulatory counsel, and execute the full range of strategic domestic and crossborder transactions. Reed Smith is a preeminent advisor to industries including financial services, life sciences, health care, advertising and media, shipping, international trade and commodities, real estate, and education. For more information, visit reedsmith.com The NASD's chief concern is that members and their associated persons should not do or give anything of value to an employee of a customer "that is intended or designed to cause, or would be reasonably judged to have the likely effect of causing," such employee to act in a manner that is inconsistent with the best interests of the customer, or any person to whom the customer owes a fiduciary duty. As stated in the Release, the guiding principle in addressing this concern is that "members should compete for business on the basis of providing the best professional services." Members are cautioned that it is inconsistent with the terms of this interpretation to use business entertainment to provide incentives to employees to conduct customer business with and/or through the member without due consideration as to whether the nature and terms of such professional services meet the objectives and are in the best interests of the account. The proposed IM builds directly on the requirement of Rule 2110 to observe "high standards of commercial honor and just and equitable principles of trade," and the Release notes that this includes the obligation of a member not to act in a manner contrary to the best interests of a customer in the conduct of business with or for such customer. • Note: Although the focus of the proposal is on NASD members that give or provide entertainment or gifts to employees of their customers, one must keep in mind the fact that in these situations, the recipients of the members' largesse may be subject to a different set of regulatory constraints and duties (for example, relevant provisions of the Investment Advisers Act of 1940). General Requirement The proposed IM would provide a general "principles-based" standard, to the effect that no member or person associated with a member shall, directly or indirectly, provide any "business -2- entertainment" to a "customer representative" pursuant to the establishment of, or during the course of, a business relationship with any "customer" that is intended or designed to cause, or would be reasonably judged to have the likely effect of causing, such customer representative to act in a manner that is inconsistent with: (1) the best interests of the customer; or (2) the best interests of any person to whom the customer owes a fiduciary duty. Definitions Under this formulation, the proposed IM would define the term “customer” to mean: (1) A person that maintains a business relationship with a member via the maintenance of an account, through the conduct of investment banking, or pursuant to other securities-related activity; or (2) A person whose customer representative receives business entertainment for the purpose of encouraging such person to establish a business relationship with the member by opening an account with the member, or by conducting investment banking or other securities-related activity with the member. The term "customer representative" would be defined to mean a person who is an employee, officer, director, or agent of a customer, unless such person is a "family member" of the customer (as defined in the proposed IM). Reed Smith is a top-15 global relationship law firm with more than 1,500 lawyers in 21 offices throughout the United States, Europe and the Middle East. Founded in 1877, the firm represents leading international businesses from Fortune 100 corporations to mid-market and emerging enterprises. Its attorneys provide litigation services in multijurisdictional matters and other high stake disputes, deliver regulatory counsel, and execute the full range of strategic domestic and crossborder transactions. Reed Smith is a preeminent advisor to industries including financial services, life sciences, health care, advertising and media, shipping, international trade and commodities, real estate, and education. For more information, visit reedsmith.com Although the Release notes that this definition would recognize a distinction between business entertainment provided directly to "natural person customers" (which is not covered by Rule 3060) and business entertainment provided to employees, agents or representatives of a customer (which is covered by Rule 3060), it also cautions that members cannot circumvent the proposal by providing business entertainment to a natural person customer who also is an employee, agent or representative of a customer, by claiming that such business entertainment applies only to the "natural person" relationship. The term "business entertainment" would be defined to mean any social event, hospitality event, sporting event, entertainment event, meal, leisure activity, or event of like nature or purpose (including business entertainment offered in connection with a charitable event, educational event or business conference), as well as any transportation or lodging related to such activity or event, in which an associated person of a member accompanies a customer representative. Note that, if a customer representative is not accompanied by an appropriate associated person of the member, any expenses associated with the business entertainment will be considered a "gift" under Rule 3060 unless "exigent circumstances" make it impractical -3- for an associated person of the member to attend, and such circumstances are handled under special procedures and are "thoroughly documented." Anything of value given or provided to a customer representative that does not fall within the definition of "business entertainment" is a gift under Rule 3060. The Release notes that this approach codifies NASD's "longstanding position" that a member must accompany or participate in an event for it to be deemed business entertainment. Thus, for example, if a member gives tickets to a sporting event but does not accompany the recipient to the event, the tickets are deemed to be a gift rather than business entertainment. Written Policies and Procedures The proposed IM would also require members to have certain specific written policies and procedures to govern business entertainment activities. Members are cautioned in this regard (with perhaps unintended irony) that they would violate the proposed interpretation not only if they failed to adopt such procedures, but also "if the procedures set standards that are so unbounded or vague that no reasonable determination of propriety can be discerned." As proposed, members must have policies and procedures that: • Reed Smith is a top-15 global relationship law firm with more than 1,500 lawyers in 21 offices throughout the United States, Europe and the Middle East. Founded in 1877, the firm represents leading international businesses from Fortune 100 corporations to mid-market and emerging enterprises. Its attorneys provide litigation services in multijurisdictional matters and other high stake disputes, deliver regulatory counsel, and execute the full range of strategic domestic and crossborder transactions. Reed Smith is a preeminent advisor to industries including financial services, life sciences, health care, advertising and media, shipping, international trade and commodities, real estate, and education. For more information, visit reedsmith.com • • • • • Define forms of business entertainment that are appropriate and inappropriate using quantitative and/or qualitative standards that address the nature and frequency of the entertainment provided, as well as the type and class of any accommodations or transportation provided in connection with such business entertainment Make clear that anything of value given or otherwise provided to a customer representative that does not fall within the definition of "business entertainment" is a gift under Rule 3060 Impose specific dollar limits on business entertainment or require advance written supervisory approval beyond specified dollar thresholds Are designed to detect and prevent business entertainment that is intended as, or could reasonably be perceived to be intended as, an improper quid pro quo or that could otherwise give rise to a potential conflict of interest or undermine the performance of a customer representative’s duty to a customer or any person to whom the customer owes a fiduciary duty Establish standards to ensure that persons designated to supervise and administer the written policies and procedures are sufficiently qualified Require appropriate training and education for all personnel who supervise, administer, or are subject to the written policies and procedures The policies and procedures should be "reasonably designed to preclude providing business entertainment that is so lavish or -4- extensive in nature that an employee would likely feel compelled to place order flow on behalf of the customer without due regard to best execution or other transaction pricing considerations." The proposed IM would also specify that, in valuing business entertainment expenses pursuant to this interpretation, a member’s written policies and procedures must specify the methodology to be used by the member to calculate the value of business entertainment. "In general, business entertainment expenses should be valued at the higher of face value or cost to the member." The proposed IM also would allow, but not require, members to establish different standards for business entertainment in connection with events that are educational, charitable, or philanthropic in nature. However, if a member chooses to do so, it should ensure that these types of business entertainment nonetheless comply with Rule 2110 and the general requirements of the proposed IM. Supervision The proposed IM stresses that "supervision is a critical component of entertainment policies and procedures." Members are free to define the approach and method of their written policies and procedures, provided they are reasonably designed to comport with the principles stated in the interpretation. In all cases, "it must be clear from the supervisory policies and procedures what factors determine appropriate levels of business entertainment and how those determinations are executed, monitored, and enforced." Reed Smith is a top-15 global relationship law firm with more than 1,500 lawyers in 21 offices throughout the United States, Europe and the Middle East. Founded in 1877, the firm represents leading international businesses from Fortune 100 corporations to mid-market and emerging enterprises. Its attorneys provide litigation services in multijurisdictional matters and other high stake disputes, deliver regulatory counsel, and execute the full range of strategic domestic and crossborder transactions. Reed Smith is a preeminent advisor to industries including financial services, life sciences, health care, advertising and media, shipping, international trade and commodities, real estate, and education. For more information, visit reedsmith.com In addition, such supervisory procedures should provide a method for evidencing both the breadth of supervisory activities as well as the information upon which such supervision is conducted. For example, a member’s policies and procedures must evidence the basis upon which a supervisor will determine that business entertainment does not violate a member’s standards as to the nature, frequency, and/or dollar amounts of entertainment. A member's policies and procedures must establish standards to ensure that persons designated to supervise and administer the member's written policies and procedures are "sufficiently qualified," i.e., that they are familiar with the applicable regulatory requirements and are sufficiently senior and experienced to entrust with the approval obligations envisioned by the member's policies and procedures. As always, the member must provide for appropriate training and education on the policies and procedures, and periodically review them to determine if they continue to be practicable and fulfill their purpose. Recordkeeping The written policies and procedures must require the maintenance of detailed records of business entertainment expenses provided to any customer representative. The member is not required to maintain records of business entertainment when the total value of the -5- business entertainment, including all expenses associated with the business entertainment, does not exceed $50 per day; or additional expenses incurred in connection with otherwise recorded business entertainment that do not, in the aggregate, exceed $50 per day. The policies and procedures must include "provisions reasonably designed to prevent associated persons of the member from circumventing the recordkeeping requirements in contravention of the spirit and purpose of this interpretation" (e.g., a pattern of providing a customer representative with business entertainment valued at $48). Finally, the policies and procedures must require that, upon a customer’s written request, the member will promptly make available to the customer any records regarding business entertainment provided to customer representatives of that customer. ***** Reed Smith is a top-15 global relationship law firm with more than 1,500 lawyers in 21 offices throughout the United States, Europe and the Middle East. Founded in 1877, the firm represents leading international businesses from Fortune 100 corporations to mid-market and emerging enterprises. Its attorneys provide litigation services in multijurisdictional matters and other high stake disputes, deliver regulatory counsel, and execute the full range of strategic domestic and crossborder transactions. Reed Smith is a preeminent advisor to industries including financial services, life sciences, health care, advertising and media, shipping, international trade and commodities, real estate, and education. For more information, visit reedsmith.com -6-